Up and Down Wall Street, Part 2

F irst off, we find it just a tad spooky that virtually all the publicly traded uniform companies -- save Cintas -- have run into some sort of trouble and the stocks have been sent to the cleaners. At the very least, that suggests other than a thriving industry and raises a question as to whether Cintas can entirely escape the woes afflicting competitors.

For example, shares of UniFirst, which makes its home in Wilmington, Massachusetts, over the past year have plunged from 18 to $9-and-change. Earnings in its most recent fiscal quarter, ended May, fell 30%. The culprits: "higher labor and fuel costs."

Won't higher fuel and labor costs hurt Cintas as well?

Moreover, Cintas has boosted its sales force 20%-25% year-over-year, and is targeting another 20% in fiscal 2001. That's a pretty big step-up to get internal revenue growth in the 14%16% range, and smacks of a company pedaling faster and faster just to maintain the same old speed.

There's a suspicion, too, that by taking large one-time charges after major pooling acquisitions and reserving heavily for bad debts and obsolete inventory, Cintas is setting aside something to "smooth" earnings. Gale adamantly denies any such rainy-day reserving, insisting that all the company's accounting is "prudently conservative."

Well, maybe. But reserving for, say, obsolete inventory does appear as perhaps a tad too conservative. In fiscal '99, for example, Cintas beefed up this $23 million reserve by $15 million, even though actual charge-offs ran $6.5 million. Thus, the balance at May '99, the most recent available figure, was a hefty-looking $31.8 million, or 19 cents a share.

One Wall Street analyst, who then had a "hold" on the stock, reckoned that as of September 1999, Cintas had reserves "to smooth reported earnings" to the tune of 10-13 cents a share. That's not an insignificant amount when 18% earnings growth was a matter of showing 17 cents more in fiscal 2000.

Worth noting, too, is that uniform companies have been strenuously competing for quite a spell, not just for new business, but for acquisitions. As a result, prices have been driven to fancy levels, even as the remaining merchandise starts to look pretty picked over. This is no small matter to Cintas, which has steadily been gobbling up competitors and in March 1999 made its biggest acquisition ever by buying Unitog, then the No. 5 uniform company.

Cintas enjoys a big leg up in the battle for acquisitions because of the premium multiple accorded its stock, now roughly three times that of its competitors. That means the company can swap its richly priced shares for acquisitions and have them, from Day One, add to earnings. But this carries risk as well as rewards, notably that Cintas will be tempted to overpay for mundane operations and ultimately undermine the sparkling growth that spurred investors to pay up for the stock in the first place.

The acquisition of Unitog is rather unsettling for this very reason. Here was a company with 4%-5% net margins -- one growing the top-line maybe 10%. A far cry from Cintas, with 20% sales growth and 10% net margins.

And what did Cintas pay? A lot. In a pooling-of-interest deal, Cintas laid out $346 million in stock and assumed $105 million in debt, for a total purchase price of $451 million. This for a company with roughly $250 million of sales and some $11 million-plus in earnings.

Over 38 times net and 1.8 times revenues for the likes of Unitog doesn't add up to getting a raging bargain. Indeed, investment bankers at the time noted that five comparable deals had been done at 0.6 to 1.3 times sales. And the price-to-sales multiple that Cintas actually paid was a still richer 2.0 when you consider that, 16 months after the deal, Unitog revenues have been pared to $220-$230 million.

Yes, it makes sense to boost margins by jettisoning lousy businesses. But cutting is easy; the tough part for Cintas will be building Unitog's sales growth up to its own 14%-16% target. On this score, the fourth quarter, ended May, wasn't exactly encouraging. Year over year, Unitog rental revenues fell 13% and, excluding sale of its linen plants, they fell 8%.

The annals of mergers and acquisitions are replete with melancholy examples of deals that failed to work out as advertised. The danger for any serial acquisitor is that its shareholders end up with a premium-priced stock attached to a company with mediocre growth.

Cintas is undeniably a premium-priced stock. Compare it with G&K Services, which is a good, if not great, company. Sure, G&K's net margins are lower, its balance sheet more leveraged and its return on equity not quite on a par with Cintas'. But over the past five years, sales and earnings per share have grown at 18.2% and 19.9%, versus Cintas' historical growth of 25.3% and 20.4%, numbers that shrink dramatically when restated on a pro forma basis to include acquisitions. Why in the world should Cintas sell at 34 times May 2001 estimates, while G&K is going for 12?

Frankly, even if William Gale is absolutely right about Cintas' prospects and we are absolutely wrong -- which we're not convinced of -- we still can't see why Cintas should sell at 45. The midpoints of Gale's earnings forecasts, as noted, imply 17% growth. A multiple equal to that growth rate gives you a stock price of $23. Heck, pay 150% -- that still gets you to only $34, which is a 10-point-plus drop from the current price.

Or look at it this way: Cintas is sporting a stock market value of $7.6 billion. But the entire uniform-rental industry -- remember, the one that grew 6% over the past decade -- is only $6 billion. In other words, Cintas is selling at a 25% premium to the whole uniform-rental market. Go figure.

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